FOOL ON THE HILL
Whitney Tilson examines how Dell calculates its return on invested capital (ROIC) and how it differs from the method he used in last week's column. While both methods are defensible, a hybrid of the two is perhaps the most appropriate. And though Dell may be a complex study in calculating ROIC, it always helps to know some of the details in case you ever encounter a trickier case.






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In last week's column, "Questioning Dell's Returns on Capital," I expressed puzzlement regarding Dell's claim, made in its latest earnings release, that it generated an 891% return on invested capital (ROIC) in its mostrecent quarter. (My calculations showed ROIC of under 100%.)
Since then, I have spent some time with a spokesman from the company discussing this issue and reviewing the figures that Dell uses to arrive at ROIC, and I believe Dell's method is one of many legitimate ways to calculate ROIC. As I noted last week, ROIC is not a scientific measure and I think that if you asked 10 experts to calculate Dell's ROIC, I bet you'd get 10 different numbers.
But ROIC is an important enough metric that it's worth spending some time on. (See Andrew Chan's column on the topic for a useful primer.) Let's dive into the numbers and examine how Dell's calculations differ from mine, and see if there is a reasonable compromise.
Net operating profit after tax
The numerator of ROIC is net operating profit after tax (NOPAT). Typically, the calculation is done using trailing 12month figures, which is what I showed last week: (All figures in millions of dollars.)
Q2 01 Q3 01 Q4 01 Q1 02 TOTAL Aftertax $515 573 412 421 1,921
operating income
Dell, however, annualizes the most recent quarter, so its number is $1,683 ($420.7 x 4).
Invested capital
The real difference is in the denominator of ROIC: invested capital. My method was to add debt plus equity, and then subtract all other cash, cash equivalents, and shortterm investments, net of 5% of annualized revenues. (Dell uses this 5% assumption for the amount of cash the business requires. One could argue that having a big cash hoard allows Dell to engage in an extended price war, such as the one currently underway,  and therefore more of it should be treated as "required" rather than "excess"  but let's go with Dell's assumption for now.)
Dell's method was to take the sum of net fixed assets and net working capital, less cash in excess of 5% of revenue. To understand the difference, let's start with Dell's most recent balance sheet: (All numbers in millions.)
Q1 02 Assets: Current Assets: Cash & cash equivalents $4,886 Shortterm investments 381 Accounts receivable, net 2,689 Inventories 350 Other 856 Total current assets 9,162 Property, plant & equipment, net 924 Investments 2,667 Goodwill & other, net 427
Total assets 13,180 Liabilities & Stockholders' Equity: Current liabilities: Accounts payable 4,326 Accrued & other 2,056 Total current liabilities 6,382 Long term debt 508 Other 785 Total liabilities 7,675 Stockholder's equity 5,505 Total liabilities & stockholders' equity 13,180
My calculation of invested capital, presented last week, is:
Q1 02 Equity $5,505 + Debt 508  Cash & equivalents 4,886  Shortterm investments 381 + 5% of annualized revenues 1,606
 = Invested capital 2,352
Dell's calculation is:
Q1 02 5% of annualized revenues $1,606 + Accounts receivable, net 2,689 + Inventories 350 + Other current assets 856 + Net fixed assets (PP&E) 924  Total current liabilities 6,382
 = Invested capital 43
Why is there such a big difference (a total of $2,309 million)? It turns out that the two methods differ in their treatment of investments, goodwill, and other longterm liabilities: Add investments of $2,667 million and goodwill of $427 million and subtract other longterm liabilities of $785 million, and you get the $2,309 million.
Let's look first at investments. Dell's method of calculating invested capital effectively treats this as excess cash and thus deducts it from invested capital, whereas my method does not. Which is right? It depends on whether you think these investments are strategic to Dell and help its operations, or whether they can be liquidated and converted into cash without any effect on the company.
I think the latter is probably closer to the truth, so this would lead one to treat most of this as cash. However, given the current state of the venture capital market, the value of these investments may be overstated, so I would argue that treating half of investments as cash and half as invested capital would be a reasonable compromise.
As for goodwill, I agree with Dell that it should be excluded. Finally, as for the "other" line item under longterm liabilities, I don't know what's included here, but I'm inclined to treat it the same as debt and equity, given that it appears alongside these items on the balance sheet.
So, if we apply these adjustments (italicized) to my methodology and Dell's, we arrive at the same figure for invested capital (again, all numbers in millions):
Using my method:
Q1 02 Equity $5,505 + Debt 508  Cash & equivalents 4,886  Shortterm investments 381 + 5% of annualized revenues 1,606  1/2 of investments 1,333.5  Goodwill 427 + Other longterm investments 785
====================================== = Invested capital 1,376.5
Using Dell's method:
Q1 02 5% of annualized revenues $1,606 + Accounts receivable, net 2,689 + Inventories 350 + Other current assets 856 + Net fixed assets (PP&E) 924  Total current liabilities 6,382 + 1/2 of investments 1,333.5
 = Invested capital 1,376.5
A final difference between our methodologies is that I use the average invested capital over the past year  consistent with using trailing12month NOPAT  which is $2,056 million after making the adjustments noted above. (I'll spare you the calculations.) Thus, ROIC is $1,921 million / $2,056 million, or 93%.
In contrast, Dell uses average invested capital over the past two quarters  consistent with using NOPAT that is annualized from the most recent quarter  which is $189 million (unadjusted) or $1,460 million (adjusted  again, I'll spare you the calculations). Thus, we can see how Dell arrived at ROIC of 891%: It's $1,683 million /$189 million. After adjusting invested capital, ROIC is 115% ($1,683 million / $1,460 million).
Adjusting for the cost of stock options
Regardless of whether you want to use 93% or 115%, Dell's ROIC appears very high. But, as I noted last week, I believe it's overstated due to Dell's liberal use of stock options to compensate its employees. How should one adjust for this?
There's quite a bit of debate on this topic, but I think using the figures presented in Dell's most recent 10K is reasonable. Under Note 6 of the "Notes to Consolidated Financial Statements" section, Dell estimates that aftertax earnings for FY 01 would have been $434 million lower had the cost of stock options been expensed. Though the figure I use for NOPAT covers Q2 01 to Q1 02, I don't think it would be far off to use the $434 million figure for FY 01 and deduct it from NOPAT of $1,921 million, reducing it to $1,487 million. Consequently, ROIC would drop to a stillhigh 72% ($1,487 million / $2,056 million) from 93%.
Conclusion
Dell presents an interesting  and complex  case study for calculating ROIC. For most companies, complex judgment calls are not required and a simple calculation like the one I used will suffice. But it always helps to know some of the details in case you ever encounter a trickier case.
 Whitney Tilson
Guest columnist Whitney Tilson is Managing Partner of Tilson Capital Partners, LLC, a New York Citybased money management firm. He did not own shares of Dell at press time. Mr. Tilson appreciates your feedback at Tilson@Tilsonfunds.com. To read his previous columns for The Motley Fool and other writings, visit http://www.tilsonfunds.com/.